Does the Neo-Keynesian model always rely on sticky wages to create unemployment? Not quite. At least two
other possibilities without sticky wages are immediately observable. The first was
identified by John Hicks as the "special
form of Mr. Keynes's theory" (Hicks, 1937:
p.109) - namely, the "liquidity trap". As Hicks originally expressed
it, the "special form" was when the income elasticity of money demand was
near-zero. Later on, the liquidity trap became identified as the case when interest
elasticity of money demand was near-infinite. Whichever the case, they both amount to the
same thing: namely, the LM curve is basically flat.

Naturally, it may seem ludicrous to presume such an extremity for the
entire LM curve, but what was suggested is that it is conceivable that the liquidity trap
emerges at very low levels of interest. Thus, the LM curve has a flat portion at low
levels of output and interest - as shown in the Figure 5. This, it was claimed, was the
case because if interest rates were very low, people would expect interest rates to rise
in the future and thus would be willing to hold any extra amount of money made available
in the interim in anticipation of that rise (i.e. there is no point in buying bonds
at low interest rates/high bond prices if one expects interest rates to rise/bond prices
to fall).

Figure 5 - The Liquidity Trap

The economy is in a "liquidity trap" if the IS curve intersects
the LM curve somewhere in this flat portion. In this case, falls in money wages may push
the LM curve to the right (in our Figure 5, from LM1 to LM2), but
the equilibrium level of output Y* and equilibrium interest rate, r* will remain virtually
unchanged and we move nowhere nearer the full employment output level, YF. In
short, the "Keynes effect" will be disabled. This was, incidentally, the only
other "Keynesian" case allowed by Modigliani
(1944).

A second possible case, as stressed by James Tobin (1947), is if the investment demand function
is interest-inelastic. In this case, the IS curve would be quite steep - in the
extreme, completely vertical - so that a rightward shift in the LM curve due to the Keynes
effect can lower interest rates all it wishes, but investment and hence aggregate demand,
equilibrium output Y* and employment will remain unchanged.

Sticky money wages, liquidity traps and
insensitive investment functions were the three rallying points for the
Neoclassical-Keynesian Synthesis. Effectively, they turned the Keynesian revolution on its
head by concluding that Keynes's theory was merely
the "special" case of a more general Neoclassical
one - true when any of these three conditions obtained, untrue otherwise. They did not
worry too much that they had, in this manner, effectively eliminated the theoretical
significance of Keynes's General Theory. After all, they
argued, Keynesian theory still had "practical" significance: these three special
cases were quite plausible in the "real world" and thus "Keynesian"
analysis was still relevant.

Nonetheless, all was not well for long. Specifically, Gottfried Haberler (1937), Tibor Scitovsky (1941) and Arthur C. Pigou (1941, 1943, 1947) postulated that the
consumption decision is based not only on current income but on "real net
wealth". Initially, "real net wealth" referred to the real supply of money
(M/p) and the real supply of bonds (B/p). The conventional Keynesian consumption function
makes consumption, at best, a function of real disposable income and interest rates, but
Haberler-Pigou proposed the inclusion of real net wealth as well, thus C = C(Y, r, V)
where V = M/p + B/p. Lloyd Metzler (1951)
subsequently argued for the inclusion of capital (K) as a component of "real net
wealth" - even if Keynesian theory disregarded it in simple IS-LM equations, that
only implied that it was assuming that bonds and capital were perfect substitutes. Thus,
we can let V = M/p + B/p + K denote "real net wealth".

The issue of why consumption is related to real net wealth is
controversial. The proposition is not, strictly speaking, that agents' "consume"
out of wealth (for that would require the sale of wealth to somebody else). Rather, it is
a sort of "feel-good" relationship: people with large amounts of wealth are
"richer" and thus "feel" as if they can consume more out of current
income. At least one economist, Lerner (1973),
questioned this reasoning, and asked mischievously to allow it to go the other way - say,
a "feel-bad" relationship between wealth and consumption (particularly if B was
composed of government bonds which people may believe they have to pay back later in
taxes).

The implication of this new consumption function should be clear. In
situations of unemployment, as money wages and price levels decline, then the real money
supply rises (the Keynes effect) which, as we saw, shifts the LM curve to the right.
However, the "Pigou Effect" (or "Real Balance" effect) implies that as
M/p rises, so does V and consequently consumption rises as well - shifting the IS curve to
the right. Thus, Pigou (1943) proposed, even
the "special cases" of a liquidity trap or interest-insensitive investment are not
sufficient to maintain unemployment equilibrium as the rightward shifts of the IS curve
via the "Pigou Effect" will ensure we are taken to full employment equilibrium.
Thus, the only possible way to have unemployment equilibrium in a Keynesian model
is if there are sticky wages and prices, period.

While many Neoclassicals cheered this development, there was a sense of
unease about these wealth effects for the implications they had for their own macroeconomic theory. Specifically, as Lloyd Metzler
noted:

"In salvaging one feature of classical economics - the automatic
tendency of the system to approach a state of full employment - Pigou and Haberler have
destroyed another feature, namely, the real theory of the interest rate." (L.A. Metzler, 1951)

In other words, the "dichotomy" between real and monetary
sectors, so cherished by Neoclassicals, was broken by the Pigou Effect as, apparently,
increases in the money supply could now affect real items like consumption, interest and
output. Was neutrality demolished?

In a careful and elaborate disquisition and elucidation, Don Patinkin (1948, 1951, 1956) arrayed various
arguments in defense of this "wealth effect". Specifically, he noted, the Neoclassical theory was contradictory anyway - it is
impossible to reconcile the Quantity Theory of Money
with the assumption of dichotomy. In fact, as he went on to argue, the "neutrality hypothesis" and the Quantity Theory
itself requires a real balance effect that violates dichotomy. Furthermore, it
helps solve the old problem of negative interest rates that the Neoclassical loanable
funds theory could not really rule out.

Following, Metzler (1951), there
are also some additional comments on the impact of prices on output. Let us push the
analysis one step further and consider allocation between liquid assets (money) and
illiquid assets (capital). If price levels decline (in unemployment, etc.), real wealth
increases, but there is also a liquidity effect because the proportion of wealth
made up of liquid money balances as opposed to illiquid capital increases. Thus, agents
have excess liquidity and will try to get rid of it by decreasing their money
demand. Thus, there can be an additional shift in the LM curve. Metzler's analysis
also led to discussions about fiscal and monetary policy - specifically, the manner
by which government increases money supply or how it finances spending will have
substantial effects on the resulting outcomes via these wealth effects. The analysis of
J.G. Gurley and E.S. Shaw (1960) and the famous fiscal policy work of Alan Blinder and Robert Solow (1973) follow Metzler's guidelines in this
regard.

However, problems quickly arose. The first was Michal Kalecki's (1944) reminder about the components of
net wealth: specifically, he noted, only "outside" money and "outside"
bonds can constitute net wealth in macroeconomic analysis. To use the terminology of
Gurley and Shaw (1960), "inside" money (i.e. bank deposits) and
"inside" bonds (private sector debt) cannot be considered part of the net wealth
of the economy because every person's asset is another person's liability so that, upon
aggregation, these inside debts will cancel out. Thus, if the Pigou Effect is to work, it
must work on the narrow components of "outside money" (high-powered money, i.e.
currency and Central Bank reserves) and "outside bonds" (i.e. government-issued
bonds and bills) and real capital - presumably, the only assets without a corresponding
liability in aggregate. Effectively, Kalecki's qualification effectively reduced at least
the empirical importance of the Pigou Effect - a fear also expressed by Pigou (1947) and Patinkin
(1948).

Don Patinkin (1956, 1972) seemed
to agree that outside wealth should be regarded only as the liabilities of the government
and real capital. However, Boris Pesek and T.R. Saving (1967) disputed this conclusion and
argued that inside money is part of the payments system and thus it provides some degree
of utility from the "services" it provides. "Money yields income to
the owner without yielding a negative income to the producer of it or to anyone else.
Consequently, money must be a part of the net wealth of the community." (Pesek and
Saving, 1967: p.246). These "services", then, ought to imply that at least some
forms of inside money ought to be considered "net wealth" in the aggregate.

In Pesek and Saving's view, inside money should be regarded as part of net
wealth provided no interest is paid on that portion. This is echoed by Harry Johnson (1969) who argues further that it does not
even matter that interest is not paid on deposits - as long as the interest gains on money
do not exceed that on alternative assets (e.g. bonds). The demand curve for money, he
argues, is like any demand curve: there is a consumer surplus. This means that for any
given level of interest, there will be some amount of money which would have been held
anyway at a higher interest. Both Pesek and Saving (1967) and Johnson (1969) argue that
the Kalecki-Gurley-Shaw definition of net wealth is inadequate and that net wealth should
be wider.

The question of public bonds has fed an even more incendiary fire.
Famously, Robert Barro (1974) attacked the notion
of government bonds being part of net wealth. In what has been later dubbed the "Ricardian Equivalence Hypothesis", Barro argued that by
issuing bonds as a method of debt-financing, the government is merely postponing the
taxation required to repay them. If households regard consumption decisions
intertemporally, they will not consider government bonds as "outside" since any
current windfall gains will be entirely offset by future expected taxation. Government
bonds, according to Barro (1974), should therefore not be included as part of net wealth -
thereby diminishing the power of the Pigou Effect even further. Others have since disputed
the assumptions underlying Barro's "Ricardian Equivalence Hypothesis" (e.g. Tobin, 1980), which we discuss more fully elsewhere.